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Chapter 10
Working With
Basic Aggregate
Demand/Supply Model
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Aggregate Demand
for Goods & Services
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Aggregate Demand
for Goods & Services


Aggregate demand curve:
-- indicates the various quantities of
domestically produced goods &
services that purchasers are willing to
buy at different price levels .
The AD curve slopes downward to the right,
indicating an inverse relationship between
the amount of goods & services demanded
and the price level.
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Aggregate Demand Curve
Price
level
A reduction in the price
level will increase the
quantity of goods &
services demanded.
P1
P2
AD
Y1
Y2
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Goods & Services
(real GDP)
Why Does the Aggregate
Demand Curve Slope Downward


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The Wealth Effect: A lower price level will
increase the purchasing power of the fixed
quantity of money.
The Interest Rate Effect: A lower price level
will make the nominal interest rate appear
lower which will stimulate additional
purchases during the current period.
The Foreign Purchases Effect: Other things
constant, a lower price level will make
domestically produced goods less expensive
relative to foreign goods.
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Factors that Shift
Aggregate Demand
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Factors that
Shift Aggregate Demand

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A decrease (increase) in Consumer Debt.
An increase in the optimism (pessimism) of
businesses and consumers about future
economic Expectations.
An increase (decrease) in Taxes.
An increase (decrease) in Real Wealth.
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Shifts in Aggregate Demand
Price
level
AD1
AD0
AD2
Goods & Services
(real GDP)
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Aggregate Supply
of Goods and Services
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Aggregate Supply
of Goods & Services


When considering the Aggregate Supply curve,
it is important to distinguish between the
short-run and the long-run.
Short-run:
-- time period during which some prices, particularly
those in resource markets, are set by prior contracts
and agreements. Therefore, in the short-run,
households and businesses are unable to adjust
these prices when unexpected changes occur,
including unexpected changes in the price level.

Long-run:
-- a time period of sufficient duration that people
have the opportunity to modify their behavior in
response to economic changes.
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Short-Run Aggregate
Supply (SRAS)
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Short-Run
Aggregate Supply (SRAS)
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

SRAS indicates the various quantities of
goods & services that domestic firms will
supply in response to changing demand
conditions that alter the level of prices in the
goods & services market.
SRAS curve slopes upward to the right.
The upward slope reflects the fact that in the
short run an unanticipated increase in the price
level will improve the profitability of firms
and they will respond with an expansion in
output.
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Short-Run Aggregate Supply Curve
Price
level
SRAS (P100)
P105
An increase in the price
level will increase the
quantity supplied in
the short run.
P100
P95
Y1
Y2
Y3
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Goods & Services
(real GDP)
Shifts in Aggregate Supply

Factors that change SRAS:



A decrease (increase) in resource prices
— that is, production costs such as wages, rent,
and interest.
A reduction (increase) in the expected rate of
inflation.
Favorable (unfavorable) supply shocks, such as
good (bad) weather or a reduction (increase) in the
world price of a key imported resource.
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Long-Run Aggregate
Supply (LRAS)
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Long-Run
Aggregate Supply (LRAS)



LRAS indicates the relationship between the
price level and quantity of output after decision
makers have had sufficient time to adjust
their prior commitments where possible.
LRAS curve is vertical.
LRAS is related to the economy's production
possibilities frontier. A higher price level does
not loosen the constraints imposed by the
economy's resource base, level of technology,
and the efficiency of its institutional
arrangements.
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Long-Run Aggregate Supply Curve
Price
level
LRAS
Change in price level
does not affect quantity
supplied in the long run.
Potential GDP
Y
F
Goods & Services
(full employment
rate of output)
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(real GDP)
Anticipated and
Unanticipated Changes
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Anticipated and
Unanticipated Changes

Anticipated changes are foreseen by
economic participants.


Decision makers have time to adjust to
them before they occur.
Unanticipated changes catch people by
surprise.
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Unanticipated Changes
in Aggregate Demand
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Unanticipated Changes
in Aggregate Demand

Impact of unanticipated reductions in AD:



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Weak demand and lower prices in the goods &
services market will reduce profit margins.
Many firms will incur losses.
Firms will reduce output, the rate of
unemployment will rise above the natural rate,
and output will temporarily fall short of the
economy's long-run potential.
With time, long-term contracts will be
modified.
Eventually, lower resource prices and a lower
real interest rate will direct the economy back
to long-run equilibrium, but this may be a
lengthy and painful process.
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Unanticipated Reduction
in Aggregate Demand
Price
level
LRAS
SRAS1
Short-run effects of an
unanticipated reduction in AD
P100
P95
AD2
Y2 YF


AD1
Goods & Services
(real GDP)
The short-run impact of an unanticipated reduction in AD
(shift from AD1 to AD2) will be a decline in output (decreases
to Y2), and a lower price level (P95).
Temporarily, profit margins decline, output falls, and
unemployment rises below its natural rate.
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Unanticipated Reduction
in Aggregate Demand
Price
level
LRAS
SRAS1
SRAS2
P100
Long-run effects of an
unanticipated reduction in AD
P95
P90
AD2
Y2 YF



AD1
Goods & Services
(real GDP)
In the long-run, weak demand and excess supply in the resource
market will lead to lower wage rates and resource prices resulting
in an expansion in short-run aggregate supply to SRAS2.
In the long-run, a new equilibrium at a lower price level (P90) and an
output consistent with the economy’s sustainable potential will result.
This method of restoring equilibrium may be both long and painful.
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Unanticipated Changes
in Aggregate Demand

Impact of unanticipated increases in AD:




Initially, the strong demand and higher price level
in the goods & services market will temporarily
improve profit margins.
Output will increase, the rate of unemployment
will drop below the natural rate, and output will
temporarily exceed the economy's long-run
potential.
With time, however, contracts will be modified
and resource prices will rise and return to their
competitive relation with product prices.
Once this happens, output will recede to the
economy's long-run potential.
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Unanticipated Increase
in Aggregate Demand
Price
level
LRAS
SRAS1
Short-run effects of an
unanticipated increase in AD
P105
P100
AD1
YF Y2

AD2
Goods & Services
(real GDP)
In response to an unanticipated increase in AD for goods & services
(shift from AD1 to AD2), prices will rise to P105 and output will
temporarily exceed full-employment capacity (increases to Y2).
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Unanticipated Increase
in Aggregate Demand
Price
level
LRAS
SRAS2
SRAS1
P110
Long-run effects of an
unanticipated increase in AD
P105
P100
AD1
YF Y2
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AD2
Goods & Services
(real GDP)
With the passage of time, prices in resource markets, including the
labor market, will rise due to the strong demand. As a result, higher
costs reduce aggregate supply to SRAS2.
In the long-run, a new equilibrium at a higher price level (P110) and an
output consistent with the economy’s sustainable potential will occur.
Thus, the increase in demand will expand output only temporarily.
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Shifts in Long Run
Aggregate Supply
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Shifts in Long Run
Aggregate Supply

Factors that change LRAS:
 An increase (decrease) in the supply
of resources.
 An improvement (deterioration) in
technology and productivity.
 Institutional changes that increase
(reduce) the efficiency of resource
use such as trade agreements.
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Impact of Changes in
Aggregate Supply
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Impact of Changes
in Aggregate Supply

Economic growth and anticipated shifts in
long-run aggregate supply.
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Increases in LRAS will make it possible to
produce and sustain a larger rate of output.
Both LRAS and SRAS will shift to the right
and output will increase.
These changes generally take place slowly
and therefore they need not disrupt long-run
equilibrium.
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Shifts in Aggregate Supply
Price
Price
level
LRAS1
YF,1


level
LRAS2
YF,2
SRAS1 SRAS2
Goods & Services
Goods & Services
(real GDP)
(real GDP)
Such factors as an increase in the stock of capital or an improvement in
technology will expand the economy’s potential output and shift the
LRAS to the right (note that SRAS will also shift to the right).
Such factors as a reduction in resource prices, favorable weather, or a
temporary decrease in the world price of an important imported resource
would shift SRAS to the right (note that LRAS will remain constant).
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Growth in Aggregate Supply
Price
level
LRAS1 LRAS2
SRAS1
SRAS2
P1
P2
AD
YFF1 YF2
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
Goods & Services
(real GDP)
Here we illustrate the impact of economic growth due to capital
formation or a technological advancement, for example.
Both LRAS and SRAS increase (to LRAS2 and SRAS2); the full
employment output of the economy expands from YF1 to YF2.
A sustainable, higher level of real output and real income is the result.
If the money supply is held constant, a new long-run equilibrium will
emerge at a larger output rate (YF2) and lower price level (P2).
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The Business Cycle
-- Revisited
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The Business Cycle
-- Revisited
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Recessions occur because prices in the
goods & services market are low relative to
the costs of production and resource prices.
The two causes of recessions:
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unanticipated reductions in aggregate
demand, and,
unfavorable supply shocks.
An unsustainable economic boom occurs
when prices in the goods & services market
are high relative to costs and resource prices.
The two causes of booms are:


unanticipated increases in aggregate
demand, and,
favorable supply shocks.
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Expansions, Recessions, and the
Rate of Unemployment
• Here we illustrate the periods
of expansion and contraction
(recession) since 1960.
• Note how the reductions in
real GDP (shaded periods) in
the top graph are associated
with increases in the rate of
unemployment well above the
natural rate (bottom graph).
• The AD/AS model indicates
that recessions are caused by
unanticipated reductions in AD
that are likely to accompany
abrupt reductions in the
inflation rate and/or adverse
supply shocks that might occur,
for example, when there is a
large increase in the price of a
key imported resource, such as
crude oil.
Expansion
Real GDP
Expansion
(billions of 1987 $)
6,000
1990
Recession
Real
GDP
4,000
1982
Recession
1980
Recession
1974–75
Recession
2,000
1970
Recession
1960
Recession
0 1960
1965
1970
1975
1980
1985
1990
1995
2000
Percentage of the
Labor Force Unemployed
Actual rate
of unemployment
10
8
6
Natural rate of
unemployment
4
(estimated range)
2
0
1960
1965
1970
1975
1980
1985
1990
Source: Derived from computerized data supplied by FAME Economics.
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1995
2000
Does the Market Have
a Self-Corrective
Mechanism That Will
Keep it on Track?
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Does the Market Have a
Self-Corrective Mechanism
That Will Keep it on Track?

There are three reasons to believe that it does:


Consumption demand is relatively stable
over the business cycle.
Changes in real interest rates will help to
stabilize aggregate demand and redirect
economic fluctuations.


Interest rates will tend to fall during a
recession and rise during and economic boom.
Changes in real resource prices will redirect
economic fluctuations.

Real resource price will tend to fall during a
recession and rise during an economic expansion.
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Changes in Real Interest Rates and
Resource Prices Over the Business Cycle
Price
LRAS
level
r
Pr
Real interest rates fall
r
(because of weak
demand for investment)
Real resource prices fall
Pr
(because of weak demand
and high unemployment)
Real interest rates rise
(because of strong
demand for investment)
Real resource prices rise
(because of strong demand
and low unemployment)
Goods & Services
Unemployment greater
than Natural Rate


YF
Unemployment less
than Natural Rate
(real GDP)
When aggregate output is less than the economy’s full employment
potential (YF), weak demand for investment leads to lower real interest
rates, while slack employment in resource markets will place
downward pressure on wages and other resource prices (Pr).
Conversely, when output exceeds YF, strong demand for capital goods
and tight labor market conditions will result in rising real interest rates
and resource prices (Pr).
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The Economy’s Self Corrective Mechanism
Price
level
LRAS
SRAS1
Lower resource
prices increase SRAS
SRAS2
In the short-run, output
may exceed or fall
short of the economy’s
full-employment
capacity (YF).
P105
P100
Lower real interest
rates increase AD
P95
AD1
Y1 YF



AD2
Goods & Services
(real GDP)
If output is temporarily less than capacity, lower interest rates
(reflecting the weak demand for investment funds) will stimulate
aggregate demand (shifting AD from AD1 to AD2).
In addition, lower resource prices will reduce production prices
(because of weak demand and abnormally high unemployment)
and thereby stimulate SRAS (shifting SRAS to SRAS2).
This output will move the economy toward full-employment
capacity. However, this self-correction process may take some time.
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The Economy’s Self Corrective Mechanism
Price
level
LRAS
In the short-run, output
may exceed or fall
short of the economy’s
full-employment
capacity (YF).
SRAS2
SRAS1
P105
P100
P95
Higher real interest
rates reduce AD
AD2
YF Y1




Higher resource
prices reduce SRAS
AD1
Goods & Services
(real GDP)
If output is temporarily greater than the economy’s potential,
higher real interest rates and resource prices will lead to a lower
but sustainable rate of output.
Higher interest rates will reduce AD (from AD1 to AD2).
At the same time, higher resource prices will increase production
costs and therefore reduce SRAS (from SRAS1 to SRAS2).
These forces direct output toward full-employment potential (YF).
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The Great Debate:
-- How rapidly does
the self-corrective
mechanism work?
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The Great Debate:
-- How rapidly does the
self-corrective mechanism work?

Many economists believe that the selfcorrective mechanism works slowly.



If this is the case, then market economies will
still experience prolonged periods of abnormally
high unemployment and below-capacity output.
Others believe that the self-corrective
mechanism works fairly rapidly if it is not
disrupted by perverse monetary and fiscal policy.
This is an important and continuing debate that
we will return to and analyze in more detail as
we proceed.
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End
Chapter 10
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